Certified506 sets out to ease pain of JOBS Act compliance work

While the possibilities afforded by the JOBS Act were welcomed by many, they created additional regulatory requirements for government agencies already struggling to keep up with existing regulation.

Roger Hauptman and Dan Gutrich saw opportunity in providing services to help market participants not only meet but exceed the compliance standards expected by those regulators.

Roger Hauptman

Mr. Hauptman and Mr. Gutrich are the co-founders of Certified506, a certification company which helps investors meet compliance requirements.

The pair founded and exited a previous company but kept in touch in the ensuing years, Mr. Gutrich said. They both were closely watching developments related to the JOBS Act.

It soon became clear regulators were going to require more diligent investor verification than they had in the past, which admittedly was a low bar, Mr. Hauptman said.

“We are seeing a phase shift in the ability to advertise offerings and to raise money in the public sector from investors. With that you also have to know the investor and not take their word they are actually an accredited investor.”

Mr. Hauptman said there is no definitive data on how many people have misrepresented their status when checking the accredited investor box but regulators have known for decades that a percentage of people who were honestly not sure if they qualified checked it anyway.

“Obviously there was a basis to change the regulations,” Mr. Hauptman said. “With self-certification there were no checks and balances.”

“It was never sufficient at the SEC as a reasonable standard.”

“The SEC is playing catchup.” – Roger Hauptman

The confluence of the JOBS Act and rapid growth of the fin-tech sector highlighted that gulf and threatened to widen it, Mr. Gutrich added.

“They’re catching up with the times. Capital is now being raised in ways they didn’t think of 10 years ago, and it will change even quicker in the next five.”

As the use of broker-dealers proliferates, less is known about investors than ever before. Projects now see investors nationwide and some will soon see them from around the world — “from people you will never meet,” Mr. Gutrich said.

“The SEC is playing catchup,” he continued. “They recognize the potential for wrong types of investors to be participating in markets.”

“Unless the SEC gets out there people who shouldn’t be investing will. They will lose lots and trouble will come.”

Certified506 focuses on discharging the SEC regulations and helping the market stay frictionless so online professionals and the host of new fundraising options they bring continue to work for the investment community and the issuers, Mr. Hauptman said.

It is also an interesting time for financial advisers, Mr. Gutrich explained. If they get involved in crowdfunded offerings, will need to be active in accessing deal flow to remain pertinent. Many others will shun the space, not wanting their clients to pursue these new deals because they diminish the adviser role.

Both Mr. Gutrich and Mr. Hauptman, while excited about the potential of these new capital raising methods, are taking a pragmatic stance when asked about how large that impact will eventually be. A recent government study showed that at the 58th percentile, only three to four percent of Americans directly invest in stocks.

“The industry thinks there will be this big rush but the reality is few actually invest in stocks,” Mr. Hauptman said. “Add in early-stage, high risk and illiquidity.”

It is important to note the percentage does not have to grow by much for a meaningful impact to be felt. If we see participation rates consistent with those of Kickstarter and Indiegogo in the rewards sector where the reward may be a T-shirt, the attraction of actual equity should be meaningful, Mr. Hauptman believes.

The best capital formation strategy depends on the type of business you are running, Mr. Hauptman cautioned. A Main Street business should have a different philosophy than someone planning on scaling to nine figures. People supporting a local business are thinking about more than their rate of return — they believe the entire community will benefit by having that coffee stand or retail shop nearby.

Be modest in your expected returns, know the risks and odds, and, if you are investing in that local operation, take pride in doing your part to help people in your community.

If you are new to crowdfunding, do not look at the most publicized examples like Oculus Rift and think such returns are commonplace, the pair advise. Yes, if you had invested $25,000 in Uber you no longer have need for a bus pass, but you are unlikely to find those opportunities on crowdfunding platforms. They have access to angel investors.

A promising strategy is to run concurrent campaigns targeting different groups, Mr. Hauptman suggested.

“A 506 (c) coupled with a regular crowdfunding campaign is compelling due to disclosure and reporting. Raise $1 million and layer in $5-$10 million with the 506 (c).”

A successful raise on Kickstarter provides a company with validation they can cite to venture capitalists.

Not every effort will be successful, and the SEC is realistic in preparing for investor losses, Mr. Hauptman said.

They may be just as concerned about what happens when the crowd picks a big winner.

When that happens issues like rights subordination and capital dilution will arise. Look no further than Oculus Rift.

If you are a startup looking for lessons from Oculus Rift, consider what they did wrong, Mr. Hauptman said.

Early on they assured investors they would never sell out and would remain independent. They would remain a developer-centric software ecosystem. People knew exactly what they were getting and it was not a security.

Under current regulations there is no way to provide such a large group with the pre-emptive rights given to major investors in venture rounds, Mr. Hauptman explained. If you aggregate investors, you are by nature depriving them of their rights.

A solution is to allow crowdfunded investments like the Oculus Rift to be structured as a special purpose vehicle (SPV), an entity whose operations are restricted to the acquisition and financing of a specific asset.

“Without an SPV structure there is no way those investors get pre-emptive rights,” Mr. Hauptman said. “By nature they are impaired right off the bat.”

“When looking ahead at the experience of crowdfunding investors who are used as seed capital to get someone to institutional capital? My gut feeling is their internal rate of return profile at the end of they is not going to be very good.”

As a hedge, stay away from early-stage to seed round companies and look for seed to cash flow-positive companies, he suggested.

I spoke with Mr. Hauptman and Mr. Gutrich in December at the Crowdfunding Professional Association’s (CfPA) Crowdfinance Summit in Washington, D.C. Members spent the day learning about unaccredited investors, big data, secondary markets and other topics that will shape the future of the industry.

The CfPA as a whole and many of its members are working to make sure the investment environment is as safe as possible. They are identifying potential trouble spots and are proactively addressing them through education, meeting with regulators, and even in how they structure their individual companies.

Certified506 is part of that movement, Mr. Gutrich said.

“Our company tries to facilitate this new market to be responsible and safe for investors while also being a functional and good market for issuers.”

Help companies know their investors so they do not inadvertently invite a liability into their capital structure. Serve as caretakers of this new market so it does not grow too fast.

“Let’s all be good actors here and exercise more diligence that statutes mandate to make sure this market self-polices and performs,” Mr. Hauptman said. “So it’s not a window where there is a frenzy of activity then massive fraud which ruins it for future generations.”

If a company takes those extra steps and the deal still goes bad then they will have nothing to worry about should the SEC stop by.

Looking ahead through 2016, Mr. Hauptman said he expects the continued destigmatization of general solicitation.

“Some see a negative selection bias if someone’s going to the crowd or generally soliciting accredited investors. They think it’s a deal that shouldn’t be funded.”

Just as we no longer need travel agents to plan that trip, more investors will see the potential of making equity or peer-to-peer investments online.

“Investing online and offering services like we are doing does not mean one has been rejected by venture capitalists,” Mr. Hauptman said.

A two-time LendIt Journalist of the Year nominee and winner in 2018, Tony has written more than 2,000 original articles on the blockchain, peer-to-peer lending, crowdfunding and emerging technologies over the past seven years, making him one of the senior writers in the alt-fi sector.

"The evolution of the crowdfunding and peer-to-peer lending scenes is absolutely fascinating to chronicle. It is a joy to be around people with such passion and vision."